Wednesday, March 25, 2009

FDI: Compulsorily Convertible Debentures

It is quite common for foreign investors to take up convertible instruments in Indian companies. These instruments are issued as either preference shares or debentures to begin with and are convertible into equity shares of the Indian company at a later date. The conversion may occur in one of two ways: either at the option of the investor, or compulsorily (without any option whatsoever). Such instruments carry characteristics of multiple securities and hence take on nomenclatures such as “hybrids” and “quasi-equity”.

From a legal and regulatory (more specifically, foreign direct investment) standpoint, however, the question is whether such convertible instruments constitute debt, thereby falling within the purview of regulations governing external commercial borrowings (ECBs), or whether they constitute equity, thereby falling under the guidelines pertaining to foreign direct investment (FDI). Previously, all preference shares with an option to convert into equity were treated as FDI, and were counted towards the sectoral caps. As regards convertible debentures, although the policy does not appear to have been entirely clear, there have been instances where convertible debentures have been allowed by the Foreign Investment Promotion Board (FIPB) under the FDI policy. In other words, wherever there was a possibility that the instrument would be converted into equity, that would be treated as equity investment for FDI purposes.

However, the policy was made significantly tighter by the Reserve Bank of India (RBI) in 2007 for preference shares and debentures whereby only fully and mandatorily convertible instruments are now considered to be FDI. All other preference shares and debentures (and including those that are optionally convertible) are considered to be debt and hence governed by the guidelines on ECBs. In its 2007 policy on convertible debentures, the RBI noted the reasons for this:
“It has been noticed that some Indian companies are raising funds under the FDI route through issue of hybrid instruments such as optionally convertible/ partially convertible debentures which are intrinsically debt-like instruments. Routing of debt flows through the FDI route circumvents the framework in place for regulating debt flows into the country. It is clarified that henceforth, only instruments which are fully and mandatorily convertible into equity, within a specified time would be reckoned as part of equity under the FDI Policy and eligible to be issued to persons resident outside India under the Foreign Direct Investment Scheme in terms of Regulation 5 (1) of Foreign Exchange Management (Transfer and Issue of shares by a Person Resident outside India) Regulations, 2000 notified vide Notification No. FEMA 20/2000-RB dated May 3, 2000.”
Subsequent to this policy change, several Indian companies have undertaken issuances of compulsorily convertible debentures to foreign investors. However, a recent news report indicates that a further review by RBI of the working of the policy is under way. The report states:
“The department of industrial policy and promotion (DIPP) has asked the Reserve Bank of India (RBI) to clarify whether compulsory convertible debentures (CCDs) are to be treated as debt or equity, …

Should the RBI decide that CCDs are to be treated as debt, corporate borrowing overseas could be affected. Funds raised through this route would then be included in external commercial borrowing, which is subject to a company-specific ceiling of $500 million. On the other hand, treating CCDs as equity would mean that such investment would have to comply with sectoral FDI limits.”
At the outset, one may wonder why there is a need for a clarification as the policy is quite unambiguous. But, it appears that the confusion arises because of the variations involved in structuring the convertible debentures, particularly the put option. As the news report further notes:
“Confusion has arisen because sometimes CCDs are structured in a way that takes them closer to debt, the official said. For example, at times CCDs have a put option which requires the issuing companies to buy back the shares issues on conversion at a fixed price. This structuring makes it debt like.”
Looking at the basic nature of the instrument, the existence of a put option that requires issuing companies to buyback shares (arising out of conversion) should not alter its character. Compulsorily convertible instruments are nothing but deferred equity; by their very terms they will become equity, albeit at a later point in time. In the interim, they partake the character of preference shares or debentures. Even when converted, the exercise of a put option on the company will be subject to the existing rules on buyback, which carry several restrictions. For instance, there are limitations on the amount that can be expended on a buyback (25% of net worth), amount of share capital that can be bought back (not exceeding 25% each year), solvency certifications from the board of directors and the like. Whether the instruments are convertible in nature or were issued as shares in the first place, there would be no difference to the outcome as these rules will have to be complied with in any case.

It is hoped that these (and other related) issues are considered by RBI while reviewing the existing guidelines or providing clarification on convertible instruments.

19 comments:

Ravi Dubey said...

I think its a nice piece of writing, however, I would like to add another dimension to the concept of "put option". From my personal experiences, I have observed that put option is normally enforced against the promoters of the company and not against the company per se.

In such a situation, I do not see that there arise any need to adhere to the buy back regulations and that is where RBI is little worried about.

Umakanth Varottil said...

Ravi, thanks for your comment. It seems from the press report that RBI was concerned about put option of CCDs against the company, but your point is indeed valid that the greater concern arises out of the put option against the promoters. Even in the latter case, the answer may lie in the method of valuation of the instrument - a lot would depend on how the CCD itself is valued. For example, if it is valued as a pure debt instrument, then it is arguable that the put option induces debt-type features into the CCD (thereby adding to RBI’s concerns) as the investor may be able to exit from the instrument by obtaining principal + interest. However, if it is valued more as an equity instrument, then it is almost akin to a transfer of shares by a non-resident investor to an Indian-resident promoter, and the relevant pricing norms would apply (requiring the investor to carry some amount of equity risk). There is perhaps a case for valuing the CCD on the lines of an equity instrument rather than a debt instrument as the primary right the CCD provides is the right to obtain equity shares in the company upon conversion (apart from interest accruals in the interim).

Shreya Lal said...

Thanks for the interesting post, Umakanth.

I wonder if the RBI proposes to clarify the permissible rate of interest payable on CCDs pending their conversion (assuming they haven’t already)? As you know, the all-in-cost of debt is capped under the ECB regime and the rate of return on preference shares is capped at 300 basis points + SBI PLR under the FDI regime. However, as the CCDs do not fall within the ECB regime and are not preference shares, it appears that if the CCDs are to be treated as equity, the interest rate pending conversion could be set at a higher level than the limits prescribed under the ECB guidelines for debt and under the FDI regime for preference shares. Presumably they may apply the preference share cap to CCDs as well.

Shreya

Umakanth Varottil said...

Shreya, thanks for your comment. That is an important issue that needs to be clarified as well, although I am not aware if that is on the agenda for reform. The issue arises due to the hybrid nature of the CCD instrument: it operates as a debenture for a while, after which it becomes a share. Hence, multiple regulations may become applicable at different points in time and for different purposes (e.g. for FDI, Companies Act, taxation, etc.). Similar issues could also arise in relation to creation of security for CCDs.

prerak said...

Hi Umakanth,

Thanks for the interesting piece. One more thought in addition to those expressed - while only CCD's amongst debentures are FDI, there is still lack of clarity on the term for which CCD's can be issued, while still being reckoned as FDI.

Regards,
Prerak Ved

Anonymous said...

i think the problem is where the put is on the promoters. so the ccd's are sold to the promoters (of course on a premium) and since these are now in the hands of indian residents ther terms can be changed, i.e. these can now be made optionally convertible.

essentially what has happened is that a foriegn investor has held a cumpl. convertible instrument, earned interest on it and then by a put on the promoters managed to get the investment back with returns. All the makings of a debt? where is the equity risk in such cases?

Anwalt said...

It is quite impressive information about to the FDI.According to the definition type of debenture which entitles the holder a right to convert the debenture into the issuer's common stocks at a specified time, conversion.hanks for the interesting info about it.

THEMASTER said...

siddhartha

Any update on the status of the FCD/ccd being treated as equity or debt.

USP said...

Indeed nice piece of information. Can you explain if the CCDs are under process of being allotted and RBI has issued UIN for transaction can the company repatriate interest on the CCD application money? further if CCDs are alloted and FC-GPR are filled and still to get acknowledged by RBI then can a company eligible to repatriate interest on the said CCD?

Deepak said...

Its g8 post Umakant, but i want to know the procedures to be followed in the following situation as there is an ambiguity in this,

1. We already issued CCD for 15 years, but we want to convert the same into equity before due date. pls tell me procedure to be followed to comply RBI & FDI policy. which should include pricing guidelines, form submission etc

Jeet said...

First of all, Umakanth Sir, thank you for bringing out such an interesting aspect of Foreign Direct Investment. I appreciate your exceptional analysis of the law and the facts. However, could you please update your article in the light of present developments whereby RBI has disapproved the sellback transaction by a foreign investor in a plain equity matter. Till now RBI has banned put options on convertible debentures and preference shares. Now it is disapproving put options on plain equity shares. Please provide your useful comments on this.

Moobiusstrip said...

Which Indian (or Foreign) Law firms are experienced with strucuturing CCD's?

Aditya said...

Hello Umakanth. Very informative post. I have a fundamental question on the nature of the CCDs. Do the CCDs leave no scope of the issuer paying back the debt (before the period after which the CCDs are to be converted into equity) and avoid conversion into equity? In other words, is it possible for the issuer of the CCD to have a call option?

V. Umakanth said...

@Aditya. Interpretations may differ, and it is not clear what stance has been adopted by the RBI, but it appears that any form of return of capital may make the instrument more removed from a "compulsorily convertible" security. In other words, the idea seems to be that the instrument will always be converted into equity - in which case the call option of the issue would go against that principle. The only situation where a return of capital is permissible is where the issue goes into liquidation where conversion is not possible and hence the convertible instrument holder would be entitled to a return of any outstanding amount if the assets are available for such payment.

Aditya said...

Thanks Umakanth for your prompt reply. I also suspected what you have said. It's a pity though, because it restricts entrepreneurs who maybe looking to raise debts (and thus take more risks than the investor) in stead of equity. There doesn't seem to be any option available today for raising debt from a foreign equity-holder, as the option of External Commercial Borrowings (ECBs) is ruled out for almost all the sectors for entrepreneurs due to restrictions on permitted end-use of the ECBs.

Thanks again.

Marc T. said...

Hello Umakanth, thank you for the detailed and informative post, I have struggled to find clear answers on this topic before so this is very helpful! I have one question on the "call option" mechanism mentioned by Aditya. My interest is more around the practical application of the law than its pure interpretation.

In practice, I have seen such call options in agreements. What is the risk of the issuer/lender signing an agreement which includes such call option? Would the RBI catch a potential irregularity while filing the agreement, or later on?

Would your answer be different if the issuer doesn't have a call option in the agreement, but simply offers the lender to repurchase the CCD at some point in time, and the lender accepts? Thanks!

Anonymous said...

Hello Mr. Umakanth,

Could you please clarify me what is the minimum and maximum period available for CCD under FEMA ?

As mentioned elsewhere above, what could be the rate of interest ( minimum and maximum) that one can offer on CCD under FEMA ?
regards

Vivek Shah said...

CCDs Issued by Indian Company against an FDI investment. No request from the holder to submit a request letter with the Original CCDs inspite of reminders.
conversion date is closing in two days. What the company shall do

mamatha said...

Thanks for the useful information.
My query regarding this is, Company needs to file form FCGPR to RBI if issues CCDs to NRIs and which requires the Valuation of the same by CA. Please let me know the rules regarding such valuation.